Real yields are the yields calculated based on real rates of return, which are adjusted for inflation. The yields are expressed in terms of real interest rates, which allow investors to accurately compare returns on investments over time.
How do we calculate the real yield of a bond?
The formula for calculating real yields is: Real Yield = Nominal Yield - the breakeven inflation rate (expected yield) of a bond of the same maturity or duration.
It is NOT simply taking away the current inflation rate from the nominal yield, which many seem to still perceive as being true!
Why are real yields important for investors?
Real yields provide a clearer picture of the returns investors can expect from an investment. By stripping out the effects of inflation and removing any time-value distortion of money, real yields more accurately reflect the actual rate of return you will earn. Moreover, as investors often need to compare investments with different durations, real yields allow investors to adequately compare investments with different durations and make more informed investment decisions.
At the moment many investors are currently looking at bonds with higher real yields, as the yield curve (the plot of yields vs maturity) is generally inverted now. This means that longer-term bonds are paying less than shorter-term bonds, and thus higher real yields can be realized for longer-term bonds. Additionally, with inflation expectations currently elevated, real yields are becoming an even more important aspect of analysing investments.
What is curve inversion?
Curve inversion is not a good sign for investors. An inverted yield curve typically indicates lower economic growth in the near future. It occurs when short-term interest rates are higher than longer-term interest rates. This means that investors are expecting a lower rate of return from long-term investments, than from short-term ones. In a healthy economy, long-term yields should be higher than short-term yields, since they reflect a better growth environment.
The 2s10s curve (difference between the US 2 year yield and the 10 year) being inverted generally means that the market perceives the Federal Reserve’s current monetary policy as too tight and that investors are pricing in lower economic activity in the near future. This can lead to higher real yields, as investors look to lock in income today in case of a looming downturn. As investors start to worry about a potential recession, real yields can become more attractive as the market prices in a weaker outlook for economic growth.
If you want to know more, we have a fantastic guide on bonds written by institutional fixed income traders, which you can view by clicking here.